Securitisation, Shadow Banking

and the Value of Financial

Innovation

Adair Turner
Chairman of the UK Financial Services Authority

School of Advanced International Studies (SAIS)

Johns Hopkins University, Washington DC
19 April 2012
17:30 EDT
 The conventional wisdom – 2006

Credit derivatives “enhance the transparency of

the markets’ collective view or credit risks…. [and Efficiency via
thus] … provide valuable information about broad price
credit conditions and increasingly set the marginal discovery
price of credit”

“There is growing recognition that the dispersion

of credit risk by banks to a broader and more
diverse group of investors, rather than
warehousing such risk on their balance sheets, has
helped make the banking and overall financial
system more resilient.” Stability via
risk
“The improved resilience may be seen in fewer
dispersion
bank failures and more consistent credit provision.
Consequently the commercial banks may be less
vulnerable today to credit or economic shocks.”
IMF Global Financial Stability Report, April 2006
1
Additional credit creation

“Securitisation is a good
thing. If everything was on
bank balance sheets, there
would not be enough
credit.”

“Senior American Regulator”, quoted in the

Economist Special Report on Financial
Innovation, February 2012

2
 Development of the crisis: 2007 – 2008

June 2007: Bear Stearns hedge funds under liquidity pressure

August 2007: Major losses by ‘market neutral’ hedge funds

February 2008: Carlyle Capital and Peloton Hedge Funds closed

Autumn 2007 to
Mid 2008: Liquidity and solvency problems at off-balance sheet SIVs

Summer 2008: Stresses at MMMFs: Reserve Primary Fund ‘breaks the buck’
August to
October 2008: Liquidity run in repo and other secured funding markets

Late autumn Hedge fund deleveraging and asset sales exacerbate

2008: downward spiral of asset values
3
 Financial Intermediation

Households Households

Non-financial
Businesses

Non-financial
Governments Businesses

Source: Financial Stability Board 4A

 Financial Intermediation

Households Households

Loans Deposits

Non-financial Banks Non-financial

Businesses
Businesses

Governments

Maturity
transformation +
leverage

Source: Financial Stability Board

4B
 Financial Intermediation

Households Households

Banks

Non-financial Non-financial
Non-financial
Businesses Businesses
Businesses

Insurance, Pension Funds +

Governments other intermediaries

Direct Investment: Bonds + Equities

• Less maturity transformation

• Less leverage

Source: Financial Stability Board 4C

 Financial Intermediation

Households Households

Banks

Non-financial Non-financial
Businesses Businesses

Securitisation
SPV

ABCP
Governments
Governments MMFs

Hedge Broker
Fund dealer Maturity/liquidity
transformation
+
leverage
… in multiple
Source: Financial Stability Board steps 4D
 Financial Intermediation

Households Households

Banks

Non-financial Non-financial
Businesses Businesses

Securitisation
SPV

ABCP
Governments
Governments MMFs

Hedge Broker
Fund dealer

Interconnected via bank sponsorship, liquidity puts, repo

markets, funding flows, securities lending
Source: Financial Stability Board 4E
5
 US mortgages on bank balance sheets and
securitised: 1952 – 2009

80%
Mortgages outstanding as % of GDP
70%

60%
BANK
50%

40%

30%

20%

10%

0%
1952

1955

1958

1961

1964

1967

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009
Private label RMBS issuers (home mortgage RMBS)
Agency and GSE backed RMBS (home mortgages)
H
Home t
mortgages

Source: U.S. Flow of Funds

6
 Money market funds and bank deposits:
US 1980-2010

US Household holdings of money US Non-Financial business holdings of

markets funds money markets funds
Percent of Household Cash and Liquid Deposits Percent of Non-Financial Business Short-Term Assets
45% 85% 70%

40% 80% Checkable

60%
Time & Saving Deposits
35% 75%
50%
30% 70%

25% 65% 40%

20% 60%
Checkable Deposits 30%

15% 55% Time & Saving

20%
10% 50%
MMMF
MMMF 10%
5% 45%

0% 40% 0%
1980 1985 1990 1995 2000 2005 2010 1980 1985 1990 1995 2000 2005 2010
Source: US Flow of Funds
Source: US Flow of Funds

7
 Growth of assets in four financial sectors
1954 – 2006

1954 Q1 = 1

Source: Brookings Papers on Economic Activity, 2010.

8
 US Asset-backed commercial paper 1990 – 2008

900
800
700
600
500
$bn

400
300
200
100
0
1990

1992

1994

1996

1998

2000

2002

2004

2006

2008
Note: Not including ABCP of chartered banks

Note: Not including ABCP of chartered banks

Source: US Flow of Funds

9
 US Repo market 1990 – 2011
US repo market ($ trillion)
5.0
4.5
4.0
3.5
3.0
US $tn

2.5
2.0
1.5
1.0
0.5
0.0
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Reverse Repo Repo

Note: US Primary Dealers only.
Source: Federal Reserve Bank of New York. 10
 US financial sector assets as % of GDP

Banks MMMFs
GSE Agency and GSE- Mortgage Pools
Issuers of ABS Finance Companies
300% Security Broker-Dealer Funding Corporation

250%

200%

150%

100%

50%

0%
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: US Flow of Funds 11
 USA debt as a % of GDP by borrower type

300%

250% Corporate

200%
Household
150%

100%
Financial
50%
10%

1971

1977
1959
1965

1983

1996

2007
1990
1941

2002
1929

1935

1947

1953

Source: Oliver Wyman

12
Underlying features of shadow banking

• Pooling, tranching (and re-tranching) to “create”

apparently low risk assets

• Marked-to-market collateral and margin to “create”

money equivalent claims

13
Real return on US treasury 20 year index-linked bond,
1999 – 2012

5%

4%

3%

2%

1%

0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

14
 Increasing demand for cash equivalent assets

Non-Financial corporations' cash Institutional Cash Pools

and cash equivalents

Source: Zoltan Pozsar, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, IMF Working Paper 11/190

15
 Banking and other financial balance sheets: in US
and Eurozone

Deposit-taking Institutions as % of GDP Other financial institution as % of GDP

400%
400%
Euroarea US
350%
350%

300% 300%

250% 250%

200% 200%
Euroarea
150% 150%
US
100% 100%

50% 50%

0% 0%
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Source: IMF World Outlook Database, US Flow of Funds; ECB Statistical Data Warehouse
16
Frequency distribution of debt payouts
Observed in good times
100%

Not observed in
good times

0
100% of principal
and due interest
17
 Financial firms’ CDS and share prices
Exhibit 1.27: Composite Time Series of Select Financial Firms' CDS and share prices
1.2% 2.50
Average CDS Spread in Percent

1.0%
2.00

MarketCap Index
0.8%
1.50

0.6%

1.00
0.4%

0.50
0.2%

0.0% -
Aug 03

Aug 04

Aug 05

Aug 06

Aug 07

Aug 08
Dec 02

Dec 03

Dec 04

Dec 05

Dec 06

Dec 07

Dec 08
Apr 03

Apr 04

Apr 05

Apr 06

Apr 07

Apr 08
CDS SHARE-PRICE-ADJUSTED
Firms included: Ambac, Aviva, Banco Santander, Barclays, Berkshire Hathaway,
Bradford & Bingley, Citigroup, Deutsche Bank, Fortis, HBOS, Lehman Brothers, Merrill
Lynch, Morgan Stanley, National Australia Bank, Royal Bank of Scotland and UBS.
CDS series peaks at 6.54% in September 2008.
Source: Moody’s KMV, FSA Calculations
18
 “We recognise the benefits of private supply of safe securities,
but at least in some cases, such securities owe their very
existence to neglected risks…

recent policy proposals, while desirable in terms of their intent to control

leverage and fire sales, do not go far enough.

It is not just the leverage but the scale of financial innovation and of the
creation of new claims itself, that might require regulatory attention”

Gennaioli, Shleifer and Vishny, 2010

19
 Bank credit and money creation

Asset Liability

Loan to non- 100 100 Deposit from

financial business non-financial
business

Not immediately repayable Immediately available “private money”

20
Maturity transformation in banks and shadow banks

BANK

Long-term Instant access /

loans short-term
deposits

SHADOW BANK CHAIN

Long-term ABCP Instant access

loans SIV / MMF “deposits”
Conduit

Hedge Broker
Fund dealer

21
 Credit and asset price cycles

Increased credit
extended

Increased
Increased lender Increased asset
borrower demand
supply of credit prices
for credit

Expectation of
future asset price
increases

Favourable
assessments of
credit risk
Low credit losses: high
bank profits
• Confidence reinforced
• Increased capital base
22
Bank credit and creation of unsecured private money

Asset Liability

Loan 100 100 Deposit

May be Not secured

secured

23
 Shadow bank credit and creation of secured
private money

Money
Hedge Broker
Borrower Dealer
Market Investor
Fund Repo / Repo Fund
Prime broker
finance

Secured money Secured money

equivalent equivalent

24
Hardwired procyclicality in secured funding
contracts

Asset value
falls

• More collateral required

even if % haircuts/margins
unchanged
• Variation margin paid

• Assets sold to cover Increased risk

margin calls awareness
• Reduced funding Increased % haircuts
available

25
 Average repo haircuts: US bilateral repo market
2007 – 2009
50.0%

45.0%

40.0%

35.0%

30.0%

25.0%

20.0%

15.0%

10.0%

5.0%

0.0%
01/01/07

01/04/07

01/07/07

01/10/07

01/01/08

01/04/08

01/07/08

01/10/08

01/01/09
Source: Gary Gorton and Andrew Metrick, “Shadow banking and the run on repo, 2009 26
Four distinctive features of financial innovation

• Regulatory arbitrage
Complexity
• Tax arbitrage
and
• Non-transparent
embedded options interconnectedness

• Excessive churn

27
 Hypothesis I:
The value of ‘market completion’
Theoretically available
allocative efficiency

Net social value derived

More complete financial markets

Negative externality of
increased potential
instability

Increased financial intensity

Complexity and interconnectedness

28
 Hypothesis II:
The value of ‘increased liquidity’?
Efficiency / price
discovery

Net social value derived?

Increased liquidity
pure momentum effects
Potential for volatility,

and arbitrary pricing

?
Increased market liquidity

Increased role of algorithmic trading

29
 Household deposits and loans: 1964 – 2009

100%

90% Securitisations and loan transfers Deposits Loans

80%

70%

60%
% of GDP

50%

40%

30%

20%

10%

0%
1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009

Source: Bank of England, Tables A4.3, A4.1 30